So you’ve made the decision to take the plunge and be an entrepreneur; to start your own business. For many of us, that decision to throw caution to the wind and be our own boss might be the hardest part. But, that doesn’t mean that the hard decisions are over. If anything, the decision to start a business is just the first of many choices that must be made before the actual “work as my own boss” part of entrepreneurship can start.
Among the first decisions that must be made is how the business will be organized. Will it be a sole proprietorship? Is it a partnership? Should a corporation be formed? What is a limited liability company? How do these titles affect the actual day-to-day basics of getting down to it and making money?
Some of the decision will be made based on whether your are going into business on your own or with partners. Some of the decision will be based on whether you might look for investors later. And some will depend on what you want your business to look like.
I spoke with some business owners I know, who work in industries ranging from the performing arts to house cleaning services, and most business owners have similar concerns. Business owners want to know whether they are protected if someone decides to sue and how taxes will work. Some new business owners may also be concerned about up-front costs and paperwork that needs to be done before they can start working.
This article will split the types of business entities into two main categories, which we’ll call “Corporate” and “Non-Corporate”. Corporate means that there is a business that exists separately from the owners; Non-Corporate means that legally, the owners are the business. We will discuss how taxes will work for each type of business and whether someone suing your business will be able to come after your house.
Non-Corporate
Non-corporate businesses are split by how many people are involved. Sole Proprietorships are a single person, while Partnerships are multiple people.
Sole Proprietor
What Kind of Paperwork Does It Take?
None. If you just start running a business, you are a sole proprietor. No registration with the state is necessary. Some businesses may wish to file their trade name with the state to protect it, but that is not required to start working.
Who Manages the Business?
The sole proprietor, as owner of all the business’s property, has exclusive control.
How Do Taxes Work?
A sole proprietor is their business and their business is the sole proprietor. A sole proprietor claims the profits from their business on their personal taxes, using the Schedule C tax form. All the profits of the business are taxed at the proprietor’s personal tax rate.
Can They Take My House?
A downside to sole proprietorship is that there is no separate business to own assets and debts. If the business ends with debts or there is a court judgment against the business, that is a debt or judgment owed by the owner and their own property can be seized to pay debts.
What Happens if I Want to Stop?
A sole proprietor just quits doing business. The business’s debts would still be owed, but since the owner owns all the business’s property, there are no special procedures for ending the business.
Partnership
What Kind of Paperwork Does it Take?
Like a sole proprietor, a partnership does not require any paperwork to be filed with the state to start working. A partnership may want to register a trade name, but that registration is not required.
It is in the partners’ best interests to write up a partnership agreement, a set of rules the partners will follow in running the business, but this is not a legal requirement. These are especially important when there is not an equal split of profits.
Who Controls the Business?
Each partner can assume full control of the business, just like a sole proprietor. Any partner can buy or sell business property and start or end certain lines of business without the consent of the other partners. This is why a partnership agreement becomes important, because it is a contract that can control the ways each partner can exert this control. If a rogue partner decides to take action that harms the other partners without permission, a partnership agreement can let the other partners take them to court to recover what was lost.
This ability to assume full control of the business means that a very high level of trust is needed with anyone you would enter a partnership with.
How Do Taxes Work?
Like a sole proprietor, each partner claims their share of the business profits on their personal taxes and each pays their own personal tax rate on their share of the profits.
Can They Take My House?
Like a sole proprietor, the partners are jointly responsible for all the debts of the business. If there is not enough business property to cover the debts, the partners’ personal homes and other property can be taken to pay off debts.
What Happens if I Want to Stop?
If any of the partners decides they no longer want to take part in the business, the business ends, all debts must be paid, and the business property must be split among the partners according to their ownership interest. A 50% owner would get 50% of all the property owned by the partnership.
If the remaining partners wished to continue business, they would need to form a new partnership after buying out the partner who left.
Limited Partnership
There is a special form of partnership available in many states called “Limited Partnership”. In a Limited Partnership, there are two different classes of partner: general and limited. For the General Partners, the partnership operates virtually the same as a regular partnership.
Where a limited partnership starts to look different is when we look at Limited Partners. A limited partner receives a share of profits, but generally does not take part in the day-to-day management of a business. This has earned them a nickname of “silent partners”. In addition, a limited partner is only liable for the debts of the business up to the amount of investment that they put into the business. This limited liability makes a Limited Partnership easier to find investors for than a general partnership.
As to how profits and taxes are handled, those work exactly the same as in a normal partnership.
The benefit of having limited liability for certain partners comes at a paperwork, and monetary, cost. Limited Partnerships must be registered with the state in which they do business, meaning that paperwork must be filed with the state before work begins, and a filing fee must be paid to the state.
Corporate Businesses
Corporate businesses differ from non-corporate by there being a business that exists separate from the owners.
The process of creating a corporation or a limited liability company is a lot like the old story of the Golem of Prague, where a being was brought to life by giving it certain words. The paperwork filed with the state defines a company and gives it a name, bringing it to life.
Corporations
What Paperwork is Required?
A corporation is formed by filing Articles of Incorporation with the state. This paperwork defines what the business will be called, how much money the corporation will start with, and how many shares the company is authorized to issue. We’ll speak more about shares a little later. The Articles must also list an “agent” who receives legal notices for the company.
In addition to the Articles, a corporation must register with the Federal Securities and Exchange Commission before issuing shares to investors, unless the corporation qualifies for an exemption. Common exemptions are for corporations who are selling a very limited number of shares or whose investors and the business are all contained in one state. More information on the exemptions is available from the Securities and Exchange Commission. Because of this need to know whether your business qualifies for an exemption, it is not recommended that you try to form your own corporation without the assistance of an attorney.
In addition to the initial paperwork, non-exempt corporations are required to make regular filings with the Securities and Exchange Commission disclosing certain financial information that investors might use to decide whether it is a good idea to invest in a company. An example of the types of information that might be sent can be seen by looking at Google’s Disclosures. Obviously, a small business would have fewer and less complicated disclosures, but Google’s make a good example of the different types of disclosures that are made.
Corporations are by far the most paperwork intensive form of business, with the paperwork requirements continuing throughout the entire life of the business.
Who Controls the Business?
As I said before, there is more talking to be done about shares. Corporations are made up of a number of shares. Each person who owns at least one of these shares is a “shareholder”.
At least once a year, the corporation must hold a meeting for all its shareholders. The corporation must send notice to each shareholder informing them of the date, time, and place the meeting will be held.
At the annual meeting, the shareholders elect a board of directors who handle the day-to-day operations of the business.
As shares are sold by original investors to other persons, it is possible that a founder may lose the support of the new shareholders and be voted off the board of directors.
The board of directors will meet more frequently than the shareholders and will follow procedures for making decisions which are contained in a company’s bylaws.
How Do Taxes Work?
A corporation files its own tax return, paying taxes at the corporate tax rate (21% as of 2018).
Profits may move to shareholders in the form of dividends. Dividends are taxed at either the individual stockholder’s personal rate or at a special dividend rate of either 15% or 20% depending on a few conditions. To qualify for the special dividend rate, the corporation must be formed in the US, must not fall into a few special industries like real estate trusts that are exempted, and the shareholder must own the shares for more than 60 days in the 120-day period starting 60 days before the dividend and ending 60 days afterward. Since most business owners will continually own the shares of their business, the 60-day rule should not hurt them.
Can They Take My House?
Corporations exist separately from their owners. Corporations own their own property and their own debts.
Because of this separate existence, owners are not liable for the debts of the corporation beyond money that is in the corporate accounts, like dividends that have yet to be paid. This limited liability is called the “Corporate Veil.”
The Corporate Veil requires, however, that an owner keep their personal finances and those of the corporation separate. If corporate money is being kept in personal accounts, those accounts can be used to pay debts.
Your house however is probably safe unless you put it in the company’s name.
What Happens If I Want to Stop?
If there’s a successful business going, you can just resign from the board and either retain your shares or sell them to somebody else. The business will continue even without any of the original owners.
If you want to wind down a corporation that is smaller, dissolving a corporation involves filing paperwork with the state where you incorporated. When a corporation is dissolved, its assets must be liquidated (sold off so that cash is on hand) and the money distributed to shareholders according to how many shares they own.
Limited Liability Company
Many attorneys, myself included, call Limited Liability Companies (LLCs) the “best of both worlds”. They combine the corporate veil with the tax simplicity of a sole proprietor or partnership.
What’s the Paperwork Like?
An LLC needs to file Articles of Organization with the state in which it is formed.
Articles of Organization work much like a corporation’s Articles of Incorporation, listing the Name and Address of the business along with an agent to receive legal service for the LLC.
Unlike corporations, there is no requirement of SEC registration or any ongoing reporting requirements.
An LLC should also create what’s called an “operating agreement” when first formed. The Operating Agreement is not filed with the state, but instead sets out the rules the business will follow. We’ll discuss the operating agreement more under both the control and taxes sections.
Who Controls the Business?
Here’s where that operating agreement comes in. An LLC is governed by an operating agreement which divides voting rights among the owners. An owner’s voting rights don’t even need to match their investment. Someone who makes a 10% investment could have 30% voting rights if the owners agree.
How Do Taxes Work?
In addition to the voting rights, the operating agreement also assigns each owner’s share of the profits. Like voting rights, the owners can agree to any split of profits they wish, even one that matches neither the initial investment nor the voting rights.
An LLC can elect to be taxed in one of two ways.
By default, an LLC is called a “pass-through entity” and taxed like a sole proprietor or partnership. Each owner pays for their share of the profits on their personal taxes as personal income at their personal rate.
An LLC can also choose to be taxed like a corporation, filing its own return and paying taxes on its profits at the Corporate rate.
LLC owners should be aware of their personal tax rates to determine whether there would be a lower tax burden under the corporate election than under pass-through rules. An attorney and tax professional can assist you in making the best election for your business.
Can They Take My House?
Like a corporation, liability for owners is limited to money and property that is owned by the business.
Also like a corporation, this limit on the liability can be lost if an owner does not keep business and personal finances separate.
What If I Want To Stop?
Interests in an LLC can be sold, though the process isn’t as easy as for a corporation. If, say, one owner sells their interest in the LLC to multiple people, a whole new operating agreement needs to be written up to divide those profits among the new owners.
Dissolving an LLC is also simpler than dissolving a corporation. The property of the LLC is divided among the owners according to their ownership interest (not the profit percentage or voting percentage) and then a notice of dissolution is filed with the state to close down the LLC.
Individual Needs Vary
Like I said in the opening paragraphs, every business is different and what type of organization is best for yours depends on many things and on what your priorities are. If you don’t mind the way taxes are handled for corporations but like the idea that new owners can be brought on and change hands easily, that may be your best choice even though you might pay a lower tax rate with an LLC.
If you are considering opening a business, you should contact a lawyer and a tax professional to discuss your options and make an informed choice in how your business should be set up.
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